An inherited IRA — also known as a beneficiary IRA — is a retirement account that is left to a person, multiple people, trust or estate after the original owner’s death.
If you’re the beneficiary of a loved one’s individual retirement account, IRS rules will determine how much, if anything, you’ll owe in taxes and whether and when you’ll have to start taking required minimum distributions. The answers are mainly based on two factors: your relationship to the deceased and whether you’ve inherited a Roth IRA or traditional IRA.
Here are five key inherited IRA rules to help you make the most of the money you inherit and avoid a tax-time surprise:
1. Spouses can take over an inherited IRA and treat it as their own
If you are the sole beneficiary of your spouse’s IRA, you can take over the account (also known as a spousal transfer or “assuming” the IRA), and the IRS will treat it as though it has been yours all along. You can do this by designating yourself as the owner of the existing account, rolling the assets from the deceased’s account into an existing IRA (either a Roth or traditional account, as long as it has the same tax treatment), or setting up a new account for this purpose.
2. Multiple beneficiaries must establish separate inherited IRA accounts
A bit more administrative legwork is required if you’re a non-spouse inheriting an IRA (solely or when it’s left to multiple people) or a spouse who is not the sole beneficiary. In all of these instances, the IRS doesn’t allow you to roll the money from an inherited IRA into one of your existing accounts. Instead, you’ll have to transfer your portion of the assets into a new IRA set up and formally named as an inherited IRA; for example, (Name of Deceased Owner) for the benefit of (Your Name). Be aware that no additional contributions are allowed in the new, inherited IRA account.
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3. Roth IRA beneficiaries can withdraw contributions tax-free at any time
Note here that we’re talking about Roth IRA contributions. Earnings from an inherited Roth can also be withdrawn tax-free, as long as the account had been open for at least five years at the time the account holder died. The so-called five-year rule is critical: If the Roth IRA was less than 5 years old at the original owner’s death, you’ll owe taxes on the earnings you withdraw. (Here are more details on the 5-year rule for Roth IRA withdrawals.)
4. You’ll likely owe taxes when withdrawing money from a traditional IRA
As tempting as it might be to cash out the account (called a lump-sum distribution), tread carefully. Going the “Vegas or bust” option could leave you owing a hefty sum when it’s time to file your taxes. Withdrawals from a traditional IRA are taxable as income, at your income tax rate, not the deceased’s, since the original account holder likely used pretax dollars to fund the account.
On the brighter side, beneficiaries who dip into a traditional IRA early don’t have to pay the 10% early withdrawal penalty on top of taxes, even if the money is withdrawn before age 59½, the age when penalty-free distributions normally begin for original account owners.
As we mentioned above, there are no early withdrawal penalties with a Roth IRA. Taking a lump-sum distribution won’t trigger taxes, as long as the account had been open for at least five years at the time the account holder died.
5. Ignoring inherited IRA RMD rules can trigger steep penalties
Required minimum distributions refer to the minimum amount you must withdraw from an IRA, typically after you turn 70½. For the original account holder, RMDs apply only to traditional IRAs. Roth IRAs don’t require RMDs until the original account holder dies.
RMD rules for beneficiaries are different, however, depending on the heir’s relationship to the deceased and/or the number of beneficiaries named. And this being the IRS, the rules can be hard to follow. In a nutshell:
- If you’re a sole spousal beneficiary of a traditional IRA: Whatever RMD rules apply to you also apply to an IRA you’ve assumed from your spouse. (See more on traditional IRA distribution rules.)
- If you’re a sole spousal beneficiary of a Roth IRA: The original account holder was not required to start taking minimum distributions at any time, and neither are you.
- If you’re a non-spouse beneficiary or a spouse who shares beneficiary status with others for a traditional IRA: In general, beneficiaries are required to take RMDs by Dec. 31 in the year of death or up until Dec. 31 of the fifth year after your loved one died. The “how much” and “when” depends on whether or not the deceased had started taking distributions and which payout method you use. What might those be, you ask? There are two main ways the IRS calculates RMDs: The life expectancy method spreads out distributions over your expected lifetime, as calculated by IRS actuarial tables. If the deceased had already started taking RMDs, the life-expectancy method will be based on their lifetime, not yours. The five-year method has the IRA fully paid out by Dec. 31 of the fifth calendar year after the year the owner died.
- If you’re a non-spouse beneficiary or a spouse who is not the sole beneficiary of a Roth IRA: With an inherited Roth, you’re allowed to postpone distributions only until the original account holder would have turned 70½, or Dec. 31 of the year following the year of death, whichever is later. After you transfer the money into an inherited IRA held in your name, you’ll choose between the life expectancy or five-year methods described above. Here’s a more detailed rundown of Roth IRA RMD rules, including a Roth IRA RMD calculator.
When it comes to RMDs, we encourage you to consult with the original source — the IRS FAQ on IRA RMDs — or a financial planner.
Mark your calendar: Miss the RMD deadline — or take less than the amount required — and the IRS will sock you with a 50% tax penalty on the amount that’s not withdrawn.
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